An idea is the basis of any new business, but control of and ability to profit from the idea is just as important. This is where equity comes in. Equity represents this control and profitability, and should be the second thing on every entrepreneur’s mind after the idea. Equity is a tool often utilized by a startup to further the business goals of the company. Keeping track of equity and putting it to work for you are two integral parts of creating a successful business.
Keeping Track of Your Equity
How can you use something that you don’t keep track of? Capital tables and professional involvement can help track equity and ensure you’re making the right decisions for your business.
A capital table, or capitalization table, is one of the easiest ways to keep track of equity. It’s a spreadsheet that records major shareholders of the company, what proportion of total capital these shareholders control and the amount of funding initially received for the capital. tThese tables are typically organized in chronological order of the equity’s acquirement.
When deciding how to put your equity to work, it’s very important to understand the legal and tax consequences of your actions. A CPA and an attorney can help you navigate these issues. Because equity changes can have unique tax ramifications, your CPA can help you structure equity deals to either reduce or delay the tax burden of the transaction. These equity deals can involve either direct investors or employees who have received equity-based compensation.
An attorney should be involved with equity deals to minimize the risk of legally-binding contracts having unintended future consequences. Whether it’s the operating agreement under which the company will function, or a convertible debt agreement with a venture capitalist, it’s important to protect the equity that controls your business. This protection can only be maximized through the services of a high-quality licensed attorney.
Putting Equity to Work
Equity is a tool primarily used to acquire assets in exchange for some portion of company control. These assets can take many forms, such as cash to fund large purchases or loyalty of employees who are essential to business operations. How can you leverage one of your most important assets?
Equity-Based Employee Compensation
Bill Harris, one of the initial executives of PayPal, emphasized the key role that equity can play in employee compensation and retention. “The people you want to attract to your business are the people who want equity. You need people who are willing to take risks. And then you need to reward them.” Equity can create dedication and loyalty from important employees, while also keeping cash in the company.
There are two ways to grant this equity-based compensation: capital interest and profit interest. A capital interest results in an employee having a claim on a set portion of the company’s assets. A profits interest entitles the employee to a portion of the future income or increase in company value. The tax consequences of these different compensation types are unique and should be discussed with a CPA.
Fundraising with Equity
The simplest way to fundraise through equity is through a direct equity investment. This avenue is common and necessary in many cases, but it is very important to understand the consequences of an equity transaction:
- Equity investors expect rewards for their risk
- Competition for equity investment is high
- Raising the equity takes time
- Once the equity is given up, that investor has some control
This equity-debt combination involves borrowing money from investors that will either be repaid with cash or equity in the company. The specifications of this transaction are usually set out in a loan agreement, which should be reviewed by your CPA and lawyer to ensure that all of the terms are addressed and appropriate. Understanding the conditions of these agreements can avoid uncertainty in a company’s equity picture. That being said, this is a useful tool if you are unable to accurately value your company at this stage, or you believe that the valuation will increase rapidly with the influx of capital from the loan.
Typical clauses of this agreement are:
- Valuation caps – a maximum equity valuation at which the investor can convert to equity
- Equity discounts – a discounted value of the amount of equity the lender can convert to from debt during the next round of equity investment
Convertible debt is typically accompanied by a reduced interest rate due to the investor’s additional flexibility gained by the equity conversion option.
Equity is an important part of your growing business and should be utilized and monitored like any of your other important assets. A greater understanding of equity and your options involving equity is an important tool to ensuring that your company reaches its potential. For more information on equity options for your company, please contact an Anders advisor.